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Has Indexing Become Too Big?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have been dumping active funds in favor of passive products. I recently sat down with Joe Brennan, Vanguard's global head of equity indexing, to discuss fund flows and whether indexing has grown too big.

Joe, thank you so much for being here.

Joe Brennan: My pleasure Christine, thanks for having me.

Benz: Let's talk about the trends in passive fund flows. Obviously they have been enormous with passive products gaining market share at the expense of active. Are there any trends when you look at that flow data that surprise you?

Brennan: As you point out the trends in the flows into low-cost, particularly passive investing have been quite strong, and we've seen that, that's been a trend now for a number of years, really investors appreciating and valuing cost as an important component to long-term returns. I think the most surprising thing is that we haven't seen the concentrated flows into narrow sectors recently. Most of the flows have been into broader based total stock market, total bond market-type of products, and I think that's investors using these as building blocks to an asset allocation.

Benz: Core building blocks that they are buying and holding. When you look at flow data, whether it's into passive products or active products, are you finding that investors are in some cases maybe taking a contrarian tack? For example, one thing we noticed was that the flows into international equity funds predated the performance resurgence in some of those markets. Are you observing any surprising trends like that?

Brennan: I'd like to think after many years of education with investors that hopefully they are taking that long-term view and looking at their overall asset allocation. And to the extent investors had been underweight, say, international investments as part of the portfolio, perhaps that has been some of the resurgence in flows into international. We see investors taking a much longer-term view, and as we've talked about for years, sort of shorter-term tactical trading usually is just a recipe for higher cost and lower net returns.

Benz: Vanguard obviously fields a very broad lineup of products. Are there any categories, when it comes to index products that Vanguard simply doesn't find appropriate to index? I know high yield, for example, has been an area where a lot of people who focus on passive products say, well maybe that's a space to go active.

Brennan: There is a couple of considerations with indexing. First, the bigger the broader the index, generally the better investment case for long-term investment. The biggest, broadest indexes are the most efficient in terms of turnover for instance. The other thing to think about with respect to indexing is investability is a key tenet in indexing. As an index manager you need to be able to actually invest appropriately per the benchmark. If the sector of the market is too illiquid, too nichey, or has operational issues that affect investability that's really an area perhaps to reconsider when it comes to indexing.

Benz: Would high yield be one area?

Brennan: Frontier markets or certain areas of the high-yield market might be challenging, yeah.

Benz: As we've discussed many investors are gravitating to passive products, but in terms of investors who maybe want to make room for both active and passive products in their portfolios, how should they decide where to use index products and where to go active?

Brennan: The active/passive balance is really interesting one. I think the one thing that's really important is to keep cost down. To the extent you have low-cost index building blocks are a great way to form a portfolio. The challenge with active management over the years has been the cost, not that active managers don't have skill and certainly many of them do. When you look at an active manager you really got to look at the team, the potential for alpha and then what they are charging for that potential. If that's a really high cost, it's going to be a losing proposition generally over the long term. I would say keep costs low, if you find an active manager that can compete over the long term and that are offering a low-cost active product, you can consider it for a portion of your portfolio. But low-cost, broad-based, index building blocks are generally a great core solution for many investors.

Benz: There has been a lot of hand wringing in the marketplace about whether, index products, ETFs are causing some mutations in how the market is behaving. What's your take on that, 'is indexing too big' question?

Brennan: This has been very big question being asked in the market these days, with all the flows going into indexing. I don't think active managers were getting the same question when active management was say 90%, 95% of the market. It's really a style of management question, and indexing is no different than other styles of management. It's a way to achieve market exposure, it's a very low-cost way and a proven one at that. The issue of market distortions--indexing represents, by the way, about 15% to 20% of global equity management. It's still pretty modest by those terms. As far as trading volumes, indexers represent less than 5% on any given day of market trading. For an indexer who is buying across broad swaths of securities representing only less than 5% of the trading volume, it's really hard for an indexer to move the market and cause distortions. Really all the market moving activity comes from that active concentrations, generally active managers deciding prices in the markets.

Benz: How large would indexing have to become to start having a meaningful impact on how the market as a whole is behaving?

Brennan: It's a really good question. I don't know that anyone has the answer to that. We think indexing can certainly be 50%, 60%, 70% of the market over the long run.

Benz: A related question is whether with the uptake in index products would that potentially create opportunities for active managers to stand out by looking different from the market?

Brennan: Two things, first of all active managers will always be able to be nimble and take advantage of opportunities in the marketplace, to the extent they are created by any types of management in the market. The biggest way an active manager can stand out is by having a real proven alpha strategy and combining that with a low-cost offering. I think the managers that remain in the market over the years will probably come to that realization and have to deal with the price issue.

Benz: Our research certainly bares out that costs are very important. Joe, thank you so much for being with us today.

Brennan: Thank you Christine.